Euro area 2023 macro-outlook: eurozone, Italy, Spain and Portugal in focus
Markets expect the European Central Bank (ECB) to press ahead with hawkish monetary policy in 2023. In the first half of the year, further interest rate hikes will keep financial conditions tight to tame high inflation, which fell back to single digits in December, fuelling hopes the worst price pressures are over. Easing energy prices have downgraded expectations for a milder eurozone recession, as higher-for-longer interest rates limit the growth outlook. Corporates and households still have considerable broad-based inflation to absorb and the impact of higher borrowing costs.
As energy inflation moderated, euro area annual inflation was 9.2 % in December 2022, down from 10.1 % in November 2022, according to Eurostat’s first estimate. Inflation expectations are broadly improving, with notable variance throughout the 27-member bloc. At the same time, the outlook for economic activity is contingent on external factors, including China’s reopening and the war’s trajectory in Ukraine.
Among the Bulls is Goldman Sachs, which no longer predicts a eurozone recession after the economy’s resilient end to 2022. Goldman expects better growth momentum, sustained lower natural gas prices and an earlier China reopening. Euro area GDP is forecast to increase by 0.6% this year, compared with an earlier forecast of a 0.1% contraction. However, the Bears suggest despite falls in oil and gas prices, subsidies to support businesses’ energy bills and signs inflation has crested, underlying price pressures remain strong.
While headline eurozone annual CPI inflation has fallen from the 10.6% peak in October to 10.1% in November and 9.2% in December, core inflation – which excludes energy and food prices – nudged up 20 basis points to 5.2% in December. ECB policymakers are waiting for a substantial fall in core inflation rate and wage growth before financial conditions can be sustainably eased. “Keeping interest rates at tight levels will reduce inflation by dampening demand and will also protect against the risk of a persistent upward shift in inflation expectations,” said Pablo Hernandez de Cos, an ECB policymaker, on Wednesday (11 January). He added that the ECB would continue to “significantly” raise interest rates at a sustained pace to ensure that inflation returns to the 2% target over the medium term.
Markets are in a secular decline in valuation multiples for equities and yields for real assets – both in Europe and the US – which will continue to play out as the ECB, and the Federal Reserve pursues further monetary tightening and unwinds legacy Quantitative Easing. In 2022, the ECB raised its deposit rate from minus 0.5% in July to 2%. Markets expect between 100 and 150 basis points worth of hikes, including two 50-basis points hikes in the ECB’s February and March meetings. Since the last ECB governing council meeting in December, markets have raised the expectation of where interest rates will peak to around 3.4%, Reuters reported ECB’s de Cos said.
At the same time, the ECB’s inflation projections for 2023 – at 6.3% – may require a downward revision if recent sharp falls in natural gas prices are sustained. Gas storage begins the New Year at high levels, which supports the case for a sustainable fall in energy prices. The ECB’s hawkish momentum risks an overtightening policy mistake that could reduce eurozone growth over the next 12 months.
For the corporate sector, receding energy inflation is only one part of the problem. Corporates enter the New Year encumbered by historically high balance sheet leverage at a time when borrowing costs are expected to remain higher for longer, and liquidity for new financing is likely to soften aligned to the weaker outlook for the economy as a whole. Lower liquidity can be, at least partially, absorbed by alternative lenders, but many more vulnerable corporates may need to sell assets ahead of refinancing events.
In a new series of articles, we will explore the macro environment in selected European economies, identifying market and sector trends to pay attention to. In a subsequent series, we will overlay the macroeconomic outlook of select European markets onto the environment for corporate and loan default risk, as well as insolvencies, administrations, and bankruptcies.
Annual CPI inflation hovered close to record highs in December – at 11.6%, compared to 11.8% in November, according to preliminary estimates, due to a fractional deceleration in energy and food costs. While headline CPI inflation has probably already passed, core inflation, which excludes energy and food prices, inched up 20 basis points to 5.8% year-on-year, signalling broad price pressures remain elevated and could still have further room to climb.
Giorgia Meloni’s centre-right coalition government, which took power last October, aims to return Italy’s public finances to prudent sustainability. However, Italy’s government debt to GDP ratio remains above 145%, one of the highest in Europe. The new government has targeted a fiscal deficit of 4.5% in 2023, down from 5.6% of GDP in 2022 and 3% in 2025, aligned to the EU’s long-term limit.
The Italian Senate voted in favour of the government’s €30 billion budget at the very end of 2022, which includes tax cuts for the self-employed and policies to ease the impact of the energy crisis, financed by a windfall tax on energy companies. One early New Year strategy by Meloni’s government was not to renew the fuel excise discount introduced by Mario Draghi’s government in March 2022. While the fuel subsidies will create savings for the government, the automatic price rises will increase operating costs for businesses and reduce households’ discretionary spending.
Italy is considered most susceptible to a debt crisis in the eurozone as the ECB raises interest rates and buys fewer bonds over 2023, a poll of economists by the Financial Times shows.
In the Bank of Italy’s baseline scenario, GDP in Italy is projected to grow by 0.4 per cent in 2023, compared with 3.8% in 2022 and 1.2% in both 2024 and 2025. Household consumption is expected to weaken early in the New Year and remain soft throughout 2023 as inflationary pressures weigh on discretionary spending. The propensity to save will decline, falling below the pre-pandemic average in 2023 and recovering only partially in the following two years. In the Italian central bank’s baseline scenario, economic activity will gradually return to growth starting next Spring and expand faster from 2024 onwards as inflationary pressures recede and uncertainty connected to the conflict in Ukraine lessens. The Italian economy is reliant on substantial fiscal support set out in the National Recovery and Resilience Plan (NRRP).
The worsening demand outlook, the rise in financing costs and heightened uncertainty will slow business investment in 2023. Tighter financial conditions and the expiry of building renovation incentives will cause investment in construction to slow. Exports will record limited growth in 2023, aligned to a broad slowdown in international trade, but will recover from 2024.
In Spain, annual CPI inflation fell back in December to 5.8%, according to the flash estimate by the Instituto Nacional de Estadistica (NSI), the lowest level since November 2021, driven by falling electricity price increases and fuel price decreases. The annual December inflation print was one percentage point below November’s 6.8% and the market consensus for December of 6.1%. However, core inflation climbed 60 basis points to 6.8%, signalling broad-based inflationary pressures remain.
GDP in Spain grew by an estimated 4.6% in 2022, according to the Bank of Spain (BOS), as the accumulative impact of inflationary pressures and tightened financial conditions weighed on household consumption and business investment. These headwinds are forecast to endure into the New Year. BOS forecasts GDP growth of 1.3% in 2023 and 2.7% in 2024. Overall, the easing in energy prices supports a modestly more bullish outlook for the year, supporting a sooner revival in household consumption and further normalisation of tourism.
In addition, the European Commission suggests the implementation of the reforms and investments under the Recovery and Resilience Plan (RRP) will support aggregate demand. The unemployment rate is set to remain stable over the next two years, at around 12.7%, while wage growth is forecast to push up this year, albeit slower than prices, which risks further households’ purchasing power erosion. Industrial production is expected to remain relatively stable, according to BOS, due to considerable legacy order backlogs.
In Portugal, economic activity is expected to slow in 2023, down to 1.5%, according to Banco de Portugal, following GDP estimates of 6.8% in 2022. In 2024 and 2025, a modest recovery to 2% is currently forecast. Portugal’s central bank cites global uncertainty, purchasing power erosion, tighter financial conditions and weakening external demand as the drivers of a material slowdown in growth this year.
From the second half of 2023, activity is expected to recover, reflecting expectations of easing tensions in energy markets, a gradual recovery in real household income, higher absorption of EU funds and an improvement in the external environment.
Annual CPI inflation was 9.6% in December, compared to 9.9% in November, according to Statistics Portugal. The annual core inflation rate, which excludes energy and unprocessed food products components, nudged up 10 basis points to 7.3%, the highest rate since December 1993. Inflation averaged 7.8% in 2022 and is projected to fall to 5.8% in 2023 and 3.3% in 2024, aligned to a gradual decrease in international commodity prices and lower demand pressures stemming from tighter monetary policy. The Portuguese labour market is expected to remain stable in the coming two years, while upside risks to wage growth and downside risks to corporate profits persist.